Wednesday, October 20, 2010

Lessons from the 1930s

Doug Irwin has a great article and podcast on the gold standard during the Great Depression. Among other things, he notes that the countries that left the gold standard the earliest--a radical policy move at the time--were the first ones to experience economic recovery. The whole discussion of how the gold standard contributed to the Great Depression is an interesting one and is instructive for today's economic issues. I wish folks like Stephen Gandel, Tyler Durden, and David Rosenberg who see the Fed's QE2 not only as ill-conceived but as also having the potential to incite civil unrest would look to this period before making such claims. If they did they would see how monetary experiments far more radical than QE2 actually ended the Great Depression. They would also see that had such programs been implemented sooner it is possible World War II may have been avoided. Although a world war is not imminent, there is the rising threat of a trade war. And yes, there are lessons from the Great Depression even for this development. Here is Doug Irwin and Barry Eichengreen:

Today, the United States is in the position of the gold-standard countries in the 1930’s. It can’t unilaterally adjust the level of the dollar against the Chinese renminbi. Employment growth continues to disappoint, and fears of deflation will not go away. Lacking other instruments with which to address these problems, the pressure for a protectionist response is growing.

So what can be done to address the situation without getting into a beggar-thy-neighbor, retaliatory free-for-all? In the deflationary 1930’s, the most important way that countries could subdue protectionist pressure was to use monetary policy actively to push up the price level and stimulate economic recovery. The same is true today. If fears of deflation were to recede, and if output and employment were to grow more vigorously, the pressure for a protectionist response would dissipate.

The villain of the piece, then, is not China, but the US Federal Reserve Board, which has been reluctant to use all the tools at its disposal to vanquish deflation and jump-start employment growth. Doing so would help to relieve the pressure in Congress to blame someone, anyone – in this case China – for America’s jobless recovery. Where the Bank of Japan has now led, the Fed should follow.

QE2 would get exported to China and other economies that peg to the dollar. Obviously, this presents problems for China and it may resist QE2, as we saw with their interest rate increase yesterday. In the long run, though, QE2 going to China and other places should provide added global stimulus and may even help rebalance the world economy.